Traders have literally thousands of different tools available to help them discern market momentum and predict future price movements, ranging from simple moving averages to complex neural networks. While any individual indicator provides limited insight, traders should consider multiple indicators in their analysis in order to get the complete picture of price action.
In addition to stock-specific tools, traders should consider market-wide tools like the so-called market breadth indicators. These indicators can provide key insights into the movements of the overall market, which are important in ensuring that traders are on the right side of a trade. In this article, we’ll take a look at market breadth and three popular indicators used to gauge it.
Be sure to also read A Trader’s Guide to Understanding Business Cycles
What Is Market Breadth?
Market breadth is a technical analysis technique that compares the number of advancing securities within an index or market to the number of declining securities. Positive market breadth occurs when there are a greater number of advancers relative to decliners, while negative market breadth occurs when there are a greater number of decliners relative to advancers in a market.
Generally, a greater number of advancing issues is an indicator of bullish sentiment and used to confirm market uptrends and vice-versa for a greater number of declining issues. There are also many derivations of market breadth calculations, such as the analysis of new 52-week highs and lows. Traders often use this information in conjunction with other technical indicators to confirm trends.
Advance-Decline Index Explained
The most basic market breadth indicator is the advance-decline index, seen in Figure 1 below, which is also known as the AD Line. By calculating the difference between the number of advancing and declining securities, the index can be very useful in confirming whether or not trends are likely to continue. Bullish markets with a negative AD Line, for instance, may be ready for a change in direction.
All charts created using StockCharts.com
In Figure 1, the stock chart shows the cumulative AD Line rather than the individual daily line since the latter can be difficult to discern any trends. The cumulative AD Line is calculated by subtracting the number of advancing stocks from the number of declining stocks within an index and then adding the previous period’s AD Line value in order to show trends in a more readable fashion.
Looking at the divergence between the actual index and the AD Line generates the most reliable buy and sell signals. Bullish divergence occurs when the actual index is moving lower and the AD Line is moving higher, signaling potential pent-up demand, while bearish divergence occurs when the actual index is moving higher and the AD Line is moving lower, signaling early selling pressure on the index.
Be sure to also read Trend Reversals: How to Spot and How to Trade
Bullish Percent Index Explained
The Bullish Percent Index (“BPI”) was developed by Abe Cohen in the mid-1950s to measure the number of stocks generating Point & Figure buy signals in a given index. Since Point & Figure charts generate a clear buy or sell signal, there is no ambiguity in calculating the BPI, although Earl Blumenthal and Mike Burke refined the process itself in the 1970s and 1980s, respectively.
For those new to P&F charts, the X’s represent upward moves and the O’s represent downward moves without any regard for time. New columns are added when a price change is great enough to indicate a reversal, with only either X’s or O’s occupying any given column. Traders use these types of charts to remove the “noise” of daily price activity in order to remove any ambiguity in reading price trends.
The BPI is calculated by dividing the number of stocks in an index generating P&F buy signals by the total number of stocks in an index. Basic P&F buy signals occur when one column of X’s exceeds the prior column of X’s, while a basic P&F sell signal happens in reverse. Traders should watch for a BPI below 30% followed by a buy signal (bull) or a reading above 70% followed by a sell signal (bear).
New Highs-Lows Index Explained
The High-Low Index (“HLI”) is a market breadth indicator designed to measure new 52-week highs relative to new 52-week lows. By dividing new highs by new highs plus new lows and then multiplying that figure by 100, traders can calculate the record high percent that can then be smoothed using a 10-day moving average to create the High-Low Index and provide key market insights.
Traders can interpret the HLI in many different ways. In general, readings below 50% suggest a greater number of new 52-week lows relative to 52-week highs and could be the early signs of a bear market. By comparing the HLI with a moving average of the HLI, such as the 20-day moving average, traders can gain insights into when new 52-week highs are slowing down and a top may be nearing.
Most traders use the HLI indicator for confirmation purposes, since 52-week highs and lows tend to be a lagging indicator. Traders may also want to compare the HLI indicators for various industries or sectors to see what areas of the market are outperforming at any given time, as well as gauge when certain markets may be overextended from excessive optimism and buying.
The Bottom Line
Market breadth indicators provide valuable insights into the movements of larger indexes to assist in analyzing individual component securities. There are several different market breadth indicators to consider, but each of them have their own set of advantages and disadvantages. Traders should use market breadth indicators as a single part of a broader technical analysis approach in order to realize the most benefit.
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